Wednesday 28 November 2018

Macro and Credit - Zollverein

"An empire founded by war has to maintain itself by war." -  Montesquieu

Watching with interest the evolution of the Brexit negotiations in conjunction with the tone down stance between Italy and the European Commission surrounding the budget, while waiting for the next G20 and potential US and China ease in trade war tensions, when it came to selecting our title analogy, we reminded ourselves of the Zollverein, or German Customs Union. The Zollverein was a coalition of German states formed to managed tariffs and economic policies within their territories, organized under the Zollverein treaties in 1833 and formally starting on the first of January 1834. The foundation of the Zollverein was the first instance in history in which independent states had consummated a full economic union without the simultaneous creation of a political federation or union. The original customs union was not ended in 1866 with outbreak of the Austro-Prussian War, but a substantial reorganization emerged in 1867. The new Zollverein was stronger, in that no individual state had a veto. The Zollverein set the groundwork for the unification of Germany under Prussian guidance. After the defeat in 1918, the German Empire was replaced by the Weimar Republic and Luxembourg left the Zollverein. The rest, as we usually say, is history...

In this week's conversation, we would like to look at what the latest widening in credit spreads mean in terms of outlook for 2019.

  • Macro and Credit - So, you want to short credit?
  • Final charts -  Change is in the air for global asset markets

  • Macro and Credit - So, you want to short credit?
While we touched in our previous conversation on the widening of credit spreads in general and the impact of falling oil prices on high beta US High Yield CCCs in particular, there has been a lot of chatter recently around the lofty valuations in leveraged loans in conjunction with the fall in prices of the asset class.

Sure no doubt US High Yield CCCs is in the line of fire when it comes to its exposure to the Energy sector:
- source Bank of America Merrill Lynch

Oil prices and US High Yield are highly connected (15%). CCC bucket is feeling the pain right now with 20.1% of exposure to the Energy sector:
- graph source Bloomberg

For sure US High Yield being "high beta" no wonder they raced ahead of the pack when it was a good time to be long Oil. Given the recent unwind of the speculative long positioning in oil and clear deterioration in the global growth narrative, no wonder credit in general and high beta in particular is starting to feel the heat and there is more "heat" to come as per the below chart from Factset displaying the S&P 500 Energy Forward 12-months EPS vs Price of oil for the last 20 years:
- graph source Factset

The divergence between US and European PMI indexes is all about credit conditions. This is why the US is ahead of the curve when it comes to economic growth compared to Europe. We have shown this before but for indicative purposes we will show it again, the US PMI versus Europe and Leveraged Loans cash prices US versus Europe - source Bloomberg from our  November 2013 conversation "In the doldrums":
- graph source Bloomberg

There is a clear relationship we think between credit and macro from our perspective. Today the picture is more contrasted. 

While previously the data for Europe's aggregate PMI was more easily available, the below charts points to a faster deterioration in global growth in Europe (red line), while in the US given the credit cycle is more "advanced", Leveraged Loan prices have started in the US to fall faster than in Europe (blue line):
- graph source Bloomberg

Many financial pundits and central bankers are clearly worried, for good reason about the froth in the Leveraged Loan markets as we are seeing not only prices falling rapidly, but the growth of the sector has been significant as per the below chart from LCD, an offering of S&P Global Market Intelligence displaying the rapid growth in US Loan Funds Assets Under Management:
- graph source LCD, an offering of S&P Global Market Intelligence 

As we pointed out again in our last conversation, our readers know by now that when it comes to credit and macro, we tend to act like any behavioral psychologist, namely that we would rather focus on the "flows" than on the "stock".  As pointed out by the website "", outflows in both leveraged loans and high yield are starting to "bite":
"Investors Withdraw $2.2B from US High Yield Bond Funds, ETFs
U.S. high-yield funds reported an outflow of $2.19 billion for the week ended Nov. 21, according to weekly reporters to Lipper only. This result reverses positive readings in the prior two weeks, and brings the year-to-date total outflow to roughly $26.5 billion.

The year-to-date total exit continues to mark an unprecedented outflow from high-yield funds, outpacing last year’s total outflow of roughly $14.9 billion, which stands as the largest exit on an annual basis to date.
Mutual funds led the way, posting their largest outflow since February at $1.51 billion. ETFs saw another $682.4 million pulled by investors during the observation period. The four-week trailing average narrowed marginally to negative $427 million, from negative $470 million in the prior week.
The change due to market conditions was a decrease of $1.49 billion, according to Lipper. Total assets at the end of the observation period were roughly $193.4 billion. ETFs account for roughly 22% of the total, at $41.8 billion. — Jon Hemingway

US Leveraged Loan Funds See Hefty $1.7B Cash Outflow
U.S. loan funds reported an outflow of $1.74 billion for the week ended Nov. 21, according to Lipper weekly reporters only. This is the second major outflow of the past four weeks, and just the eighth negative reading of 2018.
Last week’s outflow was the heaviest since the week ended Dec. 16, 2015 ($2.04 billion) and comes just three weeks after a $1.51 billion exodus over the last week of October (this excludes a nominal $1.3 billion mutual-fund outflow for the week ended Nov. 8, which came as the result of a reclassification at a single institutional investor).
With that, the four-week trailing average slumps to $767.8 million, its lowest level in nearly three years.
As with the other recent outflow, mutual funds led the way with $1.07 billion pulled out, while the total for ETFs was roughly $673 million. For ETFs that is the largest exit on record behind the $551.5 million loss for the week ended Oct. 31. Of note, ETF flows were positive in the weeks between, whereas mutual fund flows were negative for the fourth consecutive week.
While last week’s outflow puts a dent in the year-to-date total inflow, it remains a substantial $8.6 billion.
The change due to market conditions last week was a decrease of $774.3 million, the steepest decline since Dec. 16, 2015. Total assets were roughly $105.5 billion at the end of the observation period and ETFs represent about 11% of that, at roughly $12.1 billion. — Jon Hemingway - source
The S&P/LSTA US Leveraged Loan 100, which tracks the 100 largest loans in the broader Index, lost returned –0.52% in the month to date and 3.46% in the YTD. Sure some pundits would like to point out that contrary to the dismal performance of credit in 2018, in similar fashion to 2008 as indicated by Driehaus on their Twitter feed:
"YTD return is negative on each of the main US credit indexes (High Yield, Investment Grade and Aggregate). 1st time since 2008 that returns for all 3 indexes are negative through mid-November.  Lately, I find myself saying “first time since 2008” a lot more frequently" - graph source Bloomberg - Driehaus - Twitter feed.
Sure, the S&P/LSTA U.S. Leveraged Loan 100 Index is roughly around +3.5% YTD, so still overall unscathed some would argue.  Also in 2008, the index was down by a cool -28%, for perspective but we do think that if you want to go "short" credit, then indeed Leveraged Loans are a "prime" candidate" as pointed out by Peter Tchir in a July 2018 tweet:
"Many forget LCDX traded worse than HYCDX during 2008 due to positioning and then loans were more clearly senior." - source Peter Tchir, Twitter
Given the considerable size in Cov-Lite Loans in this credit cycle, then indeed, if the credit markets start unravelling, Leveraged Loans are clearly in the front line:
- graph source Bank of America Merrill Lynch

Of course Leveraged Loans, are starting to follow the painful path of other segments of the credit markets already in conjunction with global growth decelerating:

"Those of you glued to action in US equities to guide investment positions may want to devote some attention to this chart of returns to senior leveraged loans (SRLN) in excess of T-bills. Likely to be an epicenter of action in the next crisis, and currently breaking trend." - source Adam Butler - Twitter feed

Clearly if indeed credit markets start "breaking bad" in 2019, then for those of you not having the necessary ISDA to short the synthetic LCDX index could use ETFs to express their "short" view on Leveraged Loans as indicated by IHS Markit by Sam Pierson on the 26th of November in his article "ETF lending continues to thrive":
"Not all ETFs can be created out of borrowed securities, in particular those with exposure to illiquid asset classes. One such example is the Invesco Senior Loan ETF, BKLN, which consists of a basket of leveraged loans. The fund has seen increased demand from short sellers in Q4, with over $800m in current loan balances. Only a small handful of the underlying loans have any availability in securities lending, so borrowing shares from long holders of the ETF is essentially the only means of sourcing the borrow. Lenders have attempted to pass through increased rates, though the increased fees in late October and early November saw an immediate response of returned shares, driving fees lower. Once the borrow fee declined the balances picked up and fees have started to move up again. It's worth noting that BKLN has a 67bps expense ratio, which means that if short sellers can borrow for less than that rate there is an arbitrage assuming no movement in the underlying asset class. Additionally, the YTD increase in OBFR means that short selling any easy-to-borrow asset will result in a positive rebate to cash proceeds."
The $BKLN ETF is a popular way to hedge/short the asset class, in part owing the 67bps expense ratio (short sellers benefit from higher expense ratio, all else equal), though increased borrow costs over the last week may, again, dampen demand." - source Sam Pierson, Twitter feed.
As we have argued in our recent November conversation "Stalemate", Housing markets turn slowly then suddenly, same thing goes with Leveraged Loans as pointed out by Peter Tchir. 

The question that everyone is asking when it comes to credit markets as we move towards 2019 and the sell-side is sending out their outlooks is asking ourselves if we will be entering indeed a "bear" market in credit. On this subject we read with interest Morgan Stanley's synopsis and note from their 2019 Outlook for North America published on the 25th of November and entitled "The Bear Has Begun":
"We believe the credit bear market, which likely began when IG spreads hit cycle tights in Feb 2018, will continue in 2019, with HY and then eventually loans underperforming, as headwinds shift from technicals to fundamentals.
A more challenging macro backdrop: In 2018, weakening flows and tighter liquidity conditions served as the key headwinds in credit, but as an important offset, the US economy remained solid. In 2019, we think it gets tougher on both fronts – monetary policy will likely near restrictive territory for the first time this cycle, while the tailwind from a booming economy fades as growth decelerates and earnings growth potentially slows to a standstill. As that happens, late cycle risks may morph into end-of-cycle fears, continuing to break the weak links along the way, especially the more levered parts of corporate credit markets.
Late cycle and beyond: A turn in the credit cycle is not a specific point in time, but instead occurs in stages, over multiple years, beginning when growth is strong. With credit flows turning, financial conditions tightening, and idiosyncratic risks rising, we think that process has already started, slowly for now. And remember, the vulnerabilities in a cycle are always ignored on the way up. As this process continues to unfold and credit conditions tighten, the bull market excesses - this time centered around non-financial corporate balance sheets - should become increasingly clear.
A few silver linings: While we certainly do not think the consensus has embraced the idea that end-of-cycle risks are rising fairly quickly, at the least, sentiment is much less uniformly bullish than it was at the beginning of 2018. Additionally, while spreads are nowhere near where they will likely peak when the cycle fully turns, after the recent sell-off, valuations are not as extreme in places. Both of these factors help at the margin. That said, we very much stick to our bigger picture view that the credit bear market is under way, and until valuations have truly priced in long-term fundamental risks, investors should use rallies to move up-in-quality.
2019 forecasts: In our base case we forecast a -0.8% IG excess return, a 0.5% HY total return and a 1.3% loan total return. We expect $1.24tr, $183bn, and $436bn in IG, USD HY, and institutional loan gross issuance, respectively. Lastly, we project a 2.9% HY default rate.
Recommended positioning: In IG we prefer As over BBBs, Fins over non-Fins, the front-end of the curve, low $- priced bonds, US over European banks, and European over US BBBs. In HY and loans we remain up-in-quality, and prefer short-duration HY bonds. We have a modest preference for loans over HY, but think that view may change later in the year. In derivatives we prefer long CDX risk to cash, owning long-dated vol, positioning for decompression, and buying BBB CDS protection vs index." - source Morgan Stanley
As we pointed out in our previous note, credit mutual flows matter and it's probably matters as well for the Fed as well given the most recent dovish rhetoric coming from its chairman Jerome Powell. The latest price action in both the US dollar and Emerging Market equities is giving some much needed respite to the Macro tourists, which have been on the receiving end of the Fed's QT and hiking policy. 

Weakening flows clearly have been a trend this year in credit markets as indicated by Morgan Stanley in their long interesting outlook note:
"Restrictive Fed Policy and Decelerating Growth – a Tougher Combination
Tightening liquidity conditions should remain a headwind in 2019, at least initially, as the Fed pushes rates near restrictive territory, while continuing to shrink its balance sheet at the maximum rate, for now. Taking a step back, for most of 2018, we argued that a tightening in Fed policy, especially in the current cycle, was a material headwind for credit. In a nutshell, central bank stimulus was massive in this cycle, and highly supportive of credit. We thought the process in reverse, at the least, would weaken the flows into credit markets, driving higher volatility, with less of a “liquidity buffer” to cushion the shocks. In our view, these headwinds have materialized, just slowly and in stages. As we show in Exhibit 2 and Exhibit 3, flows into credit markets did weaken in 2018 across multiple sources.
Weakening flows clearly hit global credit markets this past year, one-by-one. For example, Exhibit 4 shows the spread widening in 2018 in US IG, in EM credit, in European credit, and most recently in US high yield, with financial conditions tightening in the process.

As we have frequently argued, fundamental issues are easier to hide when liquidity is flooding into markets, and it is not anymore. As liquidity conditions get squeezed, it is natural for dispersion in performance across asset classes, regions, sectors, and single names to pick up, with the weak links breaking first. US high yield was more resilient for most of the year than other markets, in part due to very low supply, and in part given its close ties to the strength in the US economy. But even HY, the "resilient" credit market, has only managed a roughly flat total return YTD, despite very strong earnings growth, a solid US economy, and supply down ~30%, which we think speaks to the importance of this tightening in liquidity conditions.
Looking to 2019 – two points are key to remember: 1) The liquidity withdrawal is going to accelerate, at first, and 2) unlike in 2018, it will happen as growth is decelerating. We think this will create an even more challenging backdrop, with the outperformance of higher beta credit fading as a result. On the first theme, as we alluded to above, our economists expect two more rate hikes in 2019 (after one more hike in December 2018).
We can debate where monetary policy sits in relation to neutral, but in our view, the flattening in the Treasury curve this past year, the tightening in financial conditions, as well as some of the weakness in key interest rate-sensitive parts of the economy, such as housing and autos, tells us that monetary policy is already pretty close to ‘tight.’ And remember, this tightening will not be just a US phenomenon going forward, as we see it. The ECB will be done buying bonds next year and hike in 4Q19, and the BoJ and BoE will hike in 2Q19, with the BoJ likely to reduce JGB purchase amounts as well, according to our economists.
But remember, throughout 2018, investors could consistently fall back on the idea that the US economy was booming with extremely strong earnings growth. Hence, it was easier to write off the multitude of macro headwinds (i.e, tighter Fed policy, tariffs, China/EM weakness, Italian politics, etc…) as “noise.” Going forward, these dynamics are changing. We expect US growth to decelerate notably, from 3.1% in 2018 to 1.7% in 2019, (with GDP growth of just 1.0% in 3Q19) as fiscal stimulus starts to fade, the interest rate-sensitive parts of the economy (i.e., autos/housing) continue to soften, financial conditions tighten, and tariffs weigh on business investment.

As we show in Exhibit 9, the global economy has already slowed, with the US bucking the trend so far, thanks in part to atypical late-cycle fiscal stimulus, but we think the US will converge to the downside as 2019 progresses.
Even more importantly, our equity strategists expect a material slowdown in earnings growth, with the likelihood of an outright earnings recession for a quarter or two in 2019 reasonably high. In their view, comps get very challenging next year, and margins will compress, with slower top-line growth and costs rising in many places, despite consensus expectations for margin expansion. We think markets are finally waking up to these earnings/growth risks with this recent sell-off.
Yes, 1.7% GDP growth is still manageable, and far from recessionary levels. In fact, one could make the case that this level of growth is ideal for credit – not too hot, not too cold. While we don’t disagree at a high level, we think details matter. In our view, slower growth in the middle of a cycle, which drives very accommodative central bank policy, is ideal. A slowdown in growth near the end of a cycle as a result of a restrictive Fed is not, and we think runs the risk that investors start to price in a higher likelihood that the cycle is coming to an end.
With growth slowing, and financial conditions tightening, will the Fed stop hiking? For now, we think the Fed "put" is fairly deep out of the money. Unlike at past points in this cycle, the Fed’s hands are more tied, with growth well above trend, unemployment at ~40 year lows, and core PCE now at 2%. That said, our economists expect the Fed to pause its rate hike cycle in 3Q19 and to end balance sheet normalization in Sep-19. For a short period of time, these dynamics could certainly boost sentiment. Longer term, we are not sure that they would be so bullish for markets. If the Fed stops hiking because they are at their perceived neutral rate and they believe inflation trends are benign, that may be positive. But if they stop hiking because the economy is weakening, that may be quite negative. In fact as we show in Exhibit 12, the biggest bouts of spread widening in a cycle, especially in HY, happen from the point when the Fed stops hiking, until deep into the rate cutting cycle, as that is when growth is rolling over.
Regardless of exactly when the Fed pauses, in this cycle, buying when growth is booming has not worked well (Exhibit 13), and we think this time will be no different as the macro backdrop reverts back down to, or even below, trend.
Adding everything up, we think macro challenges will grow in 2019. Monetary policy will continue tightening, with global central banks committed to removing stimulus, for now. All while the environment of very strong US growth and very robust earnings growth will fade. We think that backdrop will become even tougher for credit, especially some of 2018’s outperformers like US HY and loans, and continue to expose the fundamental challenges in the asset class built up over nearly a decade-long bull market." - source Morgan Stanley
Rising dispersion has clearly been the theme in 2018 when it comes to credit. The Fed's tightening stance in conjunction with QT and the surge in the US dollar have clearly been headwinds for the rest of the world. Yet the US have shown in recent months that it wasn't immune to gravity and deceleration as the fiscal boost fades in conjunctions in earnings and buybacks. 2018 also marks the return of cash in the allocation tool box and many pundits have started to play defense by parking their cash in the US yield curve front-end. Clearly the narrative has been changing and as we stated in our previous conversation:
"When the Credit facts change, I change my Credit mind. What do you do, Sir ..." - source Macronomics
Our final chart below indicates that change is in the air for global asset markets and that 2019 could prove to be even trickier than 2018 as the credit cycle continues to gradually turn.
  • Final charts -  Change is in the air for global asset markets
The latest "dovish" take from Fed Jerome Powell's speech is clearly enticing to trigger some short term rally , we do think that 2019 will eventually be even more challenging as global growth is decelerating. Our final charts come from Bank of America Merrill Lynch from their Commodity Strategies 2019 outlook from the 18th of November and show that there is a trend for higher interest rates and volatility ahead of us:
"Equity markets are sowing winds of change
While higher real interest rates have been a clear headwind to gold, the rise in the global risk free rate also seems to push up equity market volatility. Our equity derivatives team has been warning about this trend of higher interest rates and higher volatility for some time (Chart 134).

True, global equity markets have been a tale of two cities this year, with US equity markets rising and the rest of the world lagging (Chart 135). But the pickup in volatility suggests that change is in the air for global asset markets
A rising VIX will eventually force the Fed to slow...
It is easy to forget that the S&P500 total return index posted a Sharpe ratio of 3.0 last year, but it is running just on 0.5 this year. Of course, the large pick up in equity market volatility (VIX) is hurting risk-adjusted equity market returns (Chart 136).

But also equity markets have struggled to break higher this year on a number of factors. The most important issue for gold here, however, is that a further drop in equity market values could eventually encourage the Fed to slow down its monetary tightening path (Exhibit 6).

So higher equity vol will likely lend support to the yellow metal going forward." - source Bank of America Merrill Lynch
When it comes to our Zollverein analogy, while Italy continues to be a concern, we believe that France should clearly be on everyone's radar as the situation is deteriorating in conjunction with its public finances. It remains to be seen if 2019 will see the New Zollverein aka the European Union coming under pressure as it did in 1919, leading in Germany to the introduction of the Weimar Republic but, we ramble again...
"Look back over the past, with its changing empires that rose and fell, and you can foresee the future, too." - Marcus Aurelius

Stay tuned ! 

Friday 16 November 2018

Macro and Credit - Last of the Romans

 "Bad money drives out good" - Gresham’s Law

Looking at the massive capitulation and fall of oil prices, feeling somewhat liquidation from a wounded player in the market, as well as looking at the escalation in the war of words between the Trump administration and Europe, not paying enough their "fair" share for "defense", when it came to selecting our title analogy, we reminded ourselves the term "Last of the Romans". The term "Last of the Romans" (Ultimus Romanorum) has historically been used to describe an individual or individuals thought to embody the values of Ancient Roman civilization - values which, by implication, became extinct on his or their death. In the United States, "Last of the Romans" was used on numerous occasions during the early 19th century as an epithet for the political leaders and statesmen who participated in the American Revolution by signing the United States Declaration of Independence, taking part in the American Revolutionary War, or established the United States Constitution. Looking at the trajectory of the United States, with its swelling budget deficit and rapidly growing interest payments share of the budget and political polarization, when it comes to the fall of an Empire, the fall of the Roman Empire comes to mind. We read with great interest Ben Hunt's latest missive on Linkedin entitled "Foudation and Empire":

"The other way to be richer than your economy grows is to take wealth from the rest of the world. The other way is to turn alliance into empire. And then suck it dry. Or as we'd say in bloodless economic-speak, "extract rents".
The Athenians did it. The Romans did it. The British did it. And history remembers each of these imperial nations rather fondly. They were the Foundations of their day, at least as the victors write the history books.
I submit to you that the "economic nationalist" trade policies of Trump and Lighthizer and Navarro and Bannon and the rest of that crew understand this other way. I submit to you that when Trump expresses excitement over collecting some billions of dollars in Chinese tariffs, he genuinely believes that he is adding to the "wealth" of the United States. I submit to you that when Trump demands that Europe pay more for defense, his goal is to turn NATO into a profit center. I submit to you that applying a simple mercantilist lens explains 99% of our foreign policy towards Korea, Saudi Arabia, Iran and Russia.
Does this sort of rent-seeking empire-sucking foreign policy "work"? Sure, particularly if you run it like a mob protection racket. Cough, cough. I mean, of course it ultimately ends in tears and constant warfare, but hey, we've got an election to win. What's a little inertia, despotism and maldistribution among friends? " - source Ben Hunt  on
Of course as the saying goes, any resemblance to actual persons, living or dead, or actual events is purely coincidental. To make yet another parallel between Ben's must read paper and the Fall of the Roman Empire, we read with interest Cato Institute note entitled "How excessive government killed ancient Rome":
"At first, the government could raise additional revenue from the sale of state property. Later, more unscrupulous emperors like Domitian (81—96 AD.) would use trumped-up charges to confiscate the assets of the wealthy. They would also invent excuses to demand tribute from the provinces and the wealthy. Such tribute, called the aurum corinarium, was nominally voluntary and paid in gold to commemorate special occasions, such as the accession of a new emperor or a great military victory. Caracalla (198—217 AD.) often reported such dubious “victories” as a way of raising revenue. Rostovtzeff (1957: 417) calls these levies “pure robbery.”" - source Cato Institute.
While obviously the United States comes to mind when it comes to the recent spat with Europe relating to "defense" cost and extracting "rent" from their "allies", also in relation to excessive taxation and wealth confiscation, taxation levels in France have become so rapacious that the French government is facing public discontent which will come in full display on the 17th of November. Again, watch this space, because whereas everyone is focusing on the on-going Mexican standoff between Italy and  the European Commission in relation to the Italian budget, we think that France's trajectory is worth monitoring: public spending represents 56.4 % of GDP whereas the average in other countries in the European Union amounts to 47 %. We live in interesting times. Just saying...

In this week's conversation, we would like to look at what the latest fall in oil prices entails in conjunction with the rise of the US dollar, as well as the growing stress in credit and the deceleration in global growth.

  • Macro and Credit - When the Credit facts change, I change my Credit mind. What do you do, Sir ...
  • Final charts -  US Investment Grade credit, retail is finally dragging their feet...

  • Macro and Credit - When the Credit facts change, I change my Credit mind. What do you do, Sir ...
In our previous conversation, following the US midterm elections we were wondering whether we would see a period of "Goldigridlock" namely a potential end to the bear steepening experienced during the jittery month of October and some restrain on the US dollar. Obviously, the markets have seen more jitters in recent days and oil prices, as expected in our previous musing has started to put some pressure on the high beta CCC bracket in US High Yield. As we indicated in our previous conversation, in our book credit leads equity and we are closely watching credit drifting wider.

We have not been the only one watching credit drifting wider, following rising dispersion in recent months. We read recently with interest Morgan Stanley's US Economics note entitled "Cracks in Credit":
"Widening credit spreads are in focus as a recent development with potential implications for financial conditions and the economic outlook. Recent moves in credit have not had a material impact on our economic outlook to date, but the risk bears watching as a sustained tightening in corporate credit conditions can create strong headwinds for economic activity.

Policymakers at the Fed are paying close attention as well. In a recent speech, Governor Brainard judged the easy state of corporate credit conditions and narrow credit spreads as upside risk factors with respect to the economic outlook that "could push the short-run neutral [fed funds] rate above its longer-run value." But Governor Brainard was more cautious on the medium term implications, noting that "financial vulnerabilities are building" and pointed to particularly notable risks in the corporate sector, "where low spreads and loosening credit terms are mirrored by rising indebtedness among corporations that could be vulnerable to downgrades in the event of unexpected adverse developments." We interpret this to mean that policymakers believe that easy corporate credit conditions are supportive for activity today, but the unwind could generate even larger downside risks over the medium-term.
This perspective reminds us of a 2014 speech from former Fed Governor Jeremy Stein, where he warned about the risks from compressed risk and term premia resulting from the Fed's quantitative easing and forward guidance policies, and with particular focus on the economic impacts of the inevitable reversal in those risk spreads—“there is a cost associated with pushing risk premiums too low, because doing so increases the likelihood that they may revert back in a way that hinders the Federal Reserve's ability to achieve its mandated objectives.” Stein noted a "striking asymmetry" in the impact of corporate credit spreads—widening spreads were more informative and more negative for the future economic outlook, but narrowing spreads had virtually "no discernible effect at all on economic activity."
Motivated by Stein's observations, below we show a summary perspective on how credit spreads impact GDP growth and the labor market. The asymmetry of the simple relationships shown here is stark. A widening in corporate credit spreads is associated with more material and significant deterioration in GDP growth two quarters ahead (Exhibit 2), while the relationship between narrowing corporate credit spreads and two quarter ahead GDP growth is flat and insignificant (Exhibit 3).

A simple regression here finds that every 10bp sustained widening of BBB/Baa corporate credit spreads is associated with 0.3pp lower GDP growth after two quarters, all else equal. For the same narrowing in credit spreads, the effect on GDP growth is roughly zero.
The same relationship is true for labor market activity. The effect of widening credit spreads on the unemployment rate is significant and positive (Exhibit 4).

A simple regression here finds that every 10bp sustained widening of BBB/Baa corporate credit spreads is associated with a 0.15pp rise in the unemployment rate after two quarters, all else equal. For the same narrowing in credit spreads, the effect on the unemployment rate is roughly zero (Exhibit 5).
Of course we recognize that the magnitude of these simple estimates may be larger than if we incorporated these scenarios into a larger-scale dynamic macro model, so the emphasis of the analysis above is to show the asymmetric impacts on economic activity from corporate credit developments. This effect is consistent in other models as well, for example in our payrolls model where the corporate credit spread predicts employment when it widens, and the variable "turns on" in downturns, but has no impact in expansions.
Looking at credit in a broader financial conditions perspective, our modeling finds that a 100bp sustained widening in BBB credit spreads over four quarters would be the equivalent of a 62bp increase in the fed funds rate. We will be watching how credit markets evolve over the coming weeks and months to see how sustained recent moves are, and how spreads evolve in conjunction with broad financial conditions. As of the September FOMC, policymakers saw financial conditions as an upside risk to the outlook, and so the recent tightening may simply reduce that upside risk in their view. Further tightening in financial conditions may be warranted before these developments have material implications for Fed policymakers." - source Morgan Stanley
In similar fashion we will be closely watching how credit markets evolve in the coming weeks, given that as the GE story has been widely commented, we are seeing increasing rising dispersion leading to some credit spreads blowing out in spectacular fashion in some instances. This we think, is typical of a late credit cycle. We have reached a stage where credit picking skill matters. We also think that cash levels need to be raised and that the front end of the US yield curve offers again some protection in a more volatile environment.

As we indicated in our previous conversation we are watching oil prices and credit:
"Watch closely the energy sector in general and oil prices in particular because any additional weakness in oil prices would cause even more credit spread widening given the exposure to the sector of the CCC High Yield ratings bucket." - source Macronomics, November 2018
Of course we have seen this move before back in 2015 when oil prices came crashing down. DataGrapple on their blog on the 14th of November entitled "Déjà Vu":
"It is not 2015 all over again, when oil went from $100 per barrel to $42, but the roughly 25% fall in oil price from $86 per barrel to $67 since the beginning of October has eventually caught credit investors’ attention. Worries over rising oil production around the world and weakening demand from developing countries has just driven a 12-day uninterrupted fall which just ended today. Stockpiles are building, and producers are struggling to agree on production cuts. According to experts, supply will likely outstrip demand by early next year due to a potential cooling of the global economy and slower growth in China, which is in the middle of a trade war with the United States. On both sides of the Atlantic, the risk premia of oil companies have been remarked wider. The weakest American credits like Weatherford International or Transocean Inc have been impacted the most (+ 700bps at 2,457bps and +127bps at 535bps respectively over the last week), but even European names which are traditionally much more stable have seen their credit risk re-assessed. During the past week, Repsol is 19bps wider at 80bps, BP is 17bps wider at 62bps, while Equinor ASA and Total are 11bps wider at 35bps and 39bps respectively." - source DataGrapple
As economic growth decelerates as seen in Germany, Japan and Italy, China and other places, of course the fall in oil prices is biting again credit markets. This is not really surprising.

Given the pain inflicted to credit markets in particular and equities market in general falling the fall in oil prices in a recent past with a low point touched in March 2016, many pundits seems to be concerned by the recent crash in oil prices and the spillover effect it could have again. On that subject we read with interest Bank of America Merrill Lynch Situation Room note from the 14th of November entitled "Still Stormy":
"Today, not surprisingly, we received a number of questions on whether we are concerned about the recent rapid decline in oil prices. We are not (yet). As far as the high grade Energy sector is concerned, we went through a major stress-test four years ago when oil prices last plunged. That forced companies to deleverage, be conservative about capex and work to aggressively lower break-even oil prices (See: Annual Breakeven Analysis: Breakevens fall for the fifth straight year and make $45 the new $50 30 April 2018, Figure 1).

While in 2014 break-even oil prices (WTI) were $70.81/bbl they have by now nearly halved to $38.30/bbl. That leaves plenty of cushion for most companies right now – unlike in 2014.
This is a general point we have been making, by the way, that the credit quality of high grade companies is the best it has been in decades, as companies and industries have been tested and forced to improve. For example, during the commodities downturn that started four years ago, as discussed above, but also the financial crisis and Dodd-Frank greatly improved the credit quality of banks and before that the early 2000s fraud cases led to Sarbanes-Oxley. This is one key reason that in the next downturn the rate of downgrades to high yield is likely to be the lowest ever.
The other aspect of declining oil prices relevant to investors is what they signal about demand – and OPEC mentioned this. Same thing for this week’s concerns about iPhone sales. There is plenty of foreign economic weakness even though the US economy is strong. The antidote to these concerns is hard data on the US economy starting with Retail Sales and producer surveys tomorrow. The idiosyncratic stories GE, PCG and BATSLN are – well idiosyncratic. For the various macro stories such as Brexit, trade war, etc. there appears to be marginal improvement. High grade supply volumes should be on the heavy side during the remaining eight days this month where the market is open (and potentially into the first week of December). From what we are hearing this includes deals coming earlier than what we expected – such as Takeda, of which it appears the USD part will be much smaller than we thought." - source Bank of America Merrill Lynch
Sure, for Bank of America Merrill Lynch, the US economy is "plain sailing" yet, we do not adhere to their optimism. We pointed out concerns relating to US housing in our October conversation "Ballyhoo". Falling US savings rate, in conjunction with housing affordability issues on top of increasing usage of credit cards from the US consumers to maintain their level of consumption with rising PPI and surging healthcare costs for Baby Boomers, do not paint such a "rosy" picture in our book. Maybe we have been used to being too "cynical" from our "credit" perspective or simply put, maybe we are part of the Last of the Romans. There is no doubt in our mind that we are coming closer to the end of an extended credit cycle thanks to cheap credit and multiples expansion with massive buybacks.

The continuation of the rise in US interest rates is a well creating higher dispersion and more repricing of risk given the surge in "real rates" (a headwind for gold prices in true Gibson Paradox fashion one might opine). We made  the following comment on the 10th of November on another platform the following:
"Life of PI: Real rates spiked to 3.14% in late October 2008. Currently real rates have touched 1.15%. Could 2% real rates be the new pain threshold to watch for?
With real rates rising on the back of the Fed’s rate-hiking stance, no wonder we pointed out recently the divergence  between gold prices ($1,208.6) and US 5 year TIPS. With the surge of the US dollar in conjunction with the rise in real rates, this marks the return of the “Gibson paradox”:
- source Macrobond - Macronomics

Of course it might be seen as too early for the gold prices to shine again in the light of the Fed's continued hiking path, but at some point deflationary forces could reassert themselves and both gold prices and the long end of the US yield curve could benefit (yet for the latter it is hard to be enthusiastic given the aggravation of the US budget deficit).

At least there is some solace coming for the bond bulls, given that oil prices falling means that inflation is clearly moving from being a tailwind during most of the course of 2018 to a headwind for the remainder of 2018.

Also, more and more pundits are pointing towards the rising risk in corporate credit, in terms of valuations, liquidity and other metrics. It is a subject we have tackled on many occasions on this very blog. The latest ruction on GE is indicative of rising dispersion, not the start yet of the turn of the credit cycle for the worse. On that point we read with interest Bank of America Merrill Lynch's take from their Situation Room note from the 13th of November entitled "Perfect storm for credit":
"Today’s most important developments included at least the following five: 1) Monday was a bond market holiday so today fixed income investors had to catch up to yesterday’s 2% decline in equities. 2) Yesterday’s sell-off included the reaction to more negative headlines over the weekend for GE and GS. 3) We know foreign economic activity is relatively weak and investors are seeing a number of potential signs of weak demand including possibly disappointing iPhone sales and plunging oil prices (including - 7.83% today). 4) Significant new issuance volumes are looming this week and through the end of the month. 5) Meaningful decline in interest rates. That proved a perfect storm for credit and recipe for wider spreads.
Over the past month, as GE was gradually downgraded to BBB1, its outstanding bonds have now repriced not only to BBB levels, but to BB-rated levels in HY (Figure 1).

At the turn of the month, when the company’s index ratings are reduced to BBB1 GE will become the 6th largest BBB rated issuer with just shy of $50bn of outstanding index eligible debt (Figure 2). That represents 0.8% of the IG market, 1.5% of BBBs and 3.9% of HY. When General Motors and Ford were downgraded to HY in 2005 they measured 6.5% and 6.3% of the HY market, respectively. Our view is that GE is small enough, and the story sufficiently idiosyncratic, to leave other large BBB capital structures relatively little affected as this story plays out." - source Bank of America Merrill Lynch
Obviously, this has all to do with "repricing". The rise in dispersion is increasing as real rates are moving up, meaning that investors are becoming acutely more discerning to issuer profiles and trajectory. It's not only a case for credit markets, it is as well the story so far in equities with the rotation from growth stocks to value stocks and also the significant headwinds and underperformance in cyclicals in autos and housing stocks with global trade and global growth cooling down as of late. At this stage of the cycle, active stock/credit picking skills are becoming essential. Gone are the days when everything was moving up in synch as the Fed gradually tightens up the liquidity spigot through its QT policy. In that context, we continue to believe that active management should be in a better position to come back into favor. Though, for many Hedge Fund managers, the month of October has not been validating this trend so far.

When it comes to financial conditions, as we discussed recently and above, when the velocity in declining asset prices is important, this "reflexivity" feature can add up to the tightening. In terms of credit cycle and forward default rates, we look on a quarterly basis at the Fed's Senior Loan Officer Opinion Survey (SLOOs). This is what Bank of America Merrill Lynch had to say in relation to the latest survey in their Situation Room note from the 13th of November entitled "Perfect storm for credit":
"Competing harder for less business

The Fed’s fresh October senior loan officer survey released today showed weaker demand across the board for C&I, CRE, residential mortgage, auto and credit card loans. The survey cited increases in customers’ internally generated funds, reduced customer investment in plant or equipment, and customers’ borrowing having shifted to other lenders as important reasons for weaker C&I loan demand. In terms of lending standards, banks reported easing standards for C&I, mortgage, and credit card loans, while tightening standards for CRE and auto loans.
In addition, the October survey added special questions on the effect of the slope of the Treasury yield curve on lending policies. Banks responded that the change in the slope of the yield curve year-to-date “had not affected lending standards or price terms across the major loan categories.” However, “when asked their potential response to a prolonged hypothetical moderate inversion of the yield curve over the next year, banks responded that they would tighten standards or price terms across every major loan category if the yield curve were to invert, a scenario that they interpreted as a signal of a deterioration in economic conditions, likely being followed by a deterioration in the quality of their existing loan portfolio. In addition, major shares of banks reported lending would become less profitable and their bank’s risk tolerance would decrease in this scenario.”
C&I and CRE loans
In the latest October survey a net 15.9% and 3.1% of banks reported easing lending standards over the previous three months for loans to large/medium C&I firms and small C&I firms, respectively, compared to 15.9% and 7.6% in the prior July survey. For CRE loans the net share reporting tightening standards increased again to 3.9% in October from 1.9% in July. Please note that the CRE value reported here is the average for the three separate questions on loans for construction and land development, loans secured by nonfarm nonresidential structures, and loans secured by multifamily residential structures (Figure 17).

C&I loan demand weakened according to a net 14.5% of banks for large/medium firms and 10.8% for small firms, respectively, compared to a net 2.9% and 9.1% reporting stronger demand in July. For CRE loans the net share reporting weaker demand also increased to 10.9% in October from 7.2% in July (Figure 18).

Banks continued to ease lending standards for residential mortgage loans. A net 11.3% and 10.0% of banks reported loosening lending standards for GSE-Eligible and QMJumbo mortgages, respectively, compared to a net 15.3% and 4.8% in July, respectively (Figure 19).

Meanwhile, the net share reporting weaker demand for GSE-Eligible and QM-Jumbo mortgages jumped to 21.3% and 15.0% in October, respectively, from a net 5.1% and 6.6% in July (Figure 20).
Consumer loans
A net 2.2% of banks tightened lending standards for auto loans and a net 3.6% of banks loosened lending standards for credit card loans according to the fresh October survey. This is a reversal from a net 12.0% of banks loosening lending standards for auto loans and a net 3.5% of banks tightening lending standards for credit card loans in the prior (July) survey (Figure 21).

At the same time a net 1.8% and 4.3% of banks reported weaker demand for auto and credit card loans, compared to a net 3.5% of banks reporting stronger demand for auto loans and a net 2.1% of banks reporting weaker demand for credit card loans in July, respectively (Figure 22).
 - source Bank of America Merrill Lynch.

Yes, financial conditions remain very "accommodative" and it is probably the reason why the Fed will continue on its hiking path. We continue to think that investors' expectations of the Fed's number of hikes in 2019 are "undershooting".

Our readers know by now that when it comes to credit and macro, we tend to act like any behavioral psychologist, namely that we would rather focus on the "flows" than on the "stock". Our final charts below look at additional headwinds building up for US credit fund flows.

  • Final charts -  US Investment Grade credit, retail is finally dragging their feet...
When it comes to "monitoring" the evolution of the credit cycle in general and credit markets in particular, we like to look at fund flows. This is a subject we discussed in our January 2018 conversation "The Lindemann criterion":
"Fund flows have a tendency to follow total returns
Fund flows have a tendency to follow total returns, both on the way up and on the way down. When risk assets are performing well, investors do most of their saving in risky assets, and keep relatively little in cash. As the cycle matures, risk assets become more expensive and deposit rates rise, they do steadily more of their saving in safe assets. Finally as risk assets start to wobble they try and withdraw some money and do all of their saving in cash, precipitating a sell-off." - source Macronomics, January 2018
More recently in September in our conversation "The Korsakoff syndrome", we pointed out towards a Wharton paper written by Azi Ben-Rephael, Jaewon Choi and Itay Goldstein published in September and entitled "Mutual Fund Flows and Fluctuations in Credit and Business Cycles" (h/t Tracy Alloway for pointing this very interesting research paper on Twitter).

This paper points to using flows into junk bond mutual funds as a gauge of an overheated credit market to tell where we are in the credit cycle. In their paper they pointed out that investor portfolio choice towards high-yield corporate bond mutual funds is a strong predictor of all previously identified indicators of credit booms.

Our final charts come from CITI US High Grade Focus note from the 14th of November entitled "Hot topics in IG credit" and shows that inflows are vanishing, particularly from the retail side in US Investment Grade Credit and also that foreign demand is not as strong as it used to be:
"Retail has become a net drag on IG credit…
Mutual funds and ETFs that invest in IG bonds beyond 3 years to maturity are seeing inflows vanish…
– Between 2015 and 2017, mutual funds focused on the IG asset class absorbed slightly more than their share of net issuance of three-year and longer IG paper, providing a solid foundation for credit spreads during periods of turbulence. Fund inflows into all IG categories excluding funds with a short-maturity focus grew at an annual rate of 10%-15% of fund assets at a time when the market for IG corporate bonds with greater than 3 years to maturity grew between 7%-9%. As the (3yr) IG market growth rate has slowed to 3%, fund inflows are turning south. On a 3m annualized basis, the mutual fund and ETF community is seeing outflows at an annualized rate of roughly 5%. (Figure 1).

We prefer to exclude developments in short duration IG funds because their lower rate sensitivity; indeed, short-duration funds continue to receive healthy inflows with 1-4 year duration single-A IG yields at 3.51%. That's only 55 bps lower than the yield of single-A 4-9 year duration bonds. The post-crisis average yield difference is 133 bps.
 … as Treasury yields weigh on investor sentiment
– We contrast the rate of inflows into US IG mutual funds focused on maturities greater than three years against the year-over-year change in 10-year Treasury yields in Figure 2.

The momentum in yields provides a strong signal about changes the direction of fund flows, perhaps because households base expectations for rate changes on current trends. In the 2013 "Taper Tantrum" year-over-year changes in Treasury yields moved from -150 to +100 as fund inflows dropped from +20% to -10%. On a 3m basis, outflows maxed out at an annualized rate of 25%. Citi's  10Y rate view of 2.85% portends a slight positive for the fund outlook. Retail outflows become a greater concern if the IG market returns to a 5-10% market growth rate.
…while the international demand picture is growing more complex
To start on a bright spot, Taiwanese investors are pumping cash into US IG through local ETFs…
– Taiwanese financial institutions have introduced locally listed foreign bond ETFs at a rate of one new ETF per two weeks in 2018, and the pace has increased to one per week since the beginning of August. (Figure 1).

In the past two months alone, these ETFs have seen inflows of $2.8 billion, of which $1 billion was directed toward DM IG paper. The fastest-growing ETFs focus on tech, bank, telecom, BBB and 4.5% coupon or higher paper; all are focused on bonds with at least 15 years to maturity. Taiwan lifers are awaiting a rule change expected to provide new avenues around a 45% cap on foreign corporate bonds (e.g. underwriting more USD-denominated policies). Until then, buying ETFs (and classifying them as local equities) could provide an alternative means to gain access to long-duration, higher-yielding paper. Demand from ETFs is more dispersed than traditional Taiwan flows, which may eliminate some technical pressure on the 10s30s curves of particular issuers and securities.
 … although the broader picture for currency-hedged foreign inflows into US IG corporate bonds is somewhat bleak
– The trailing 12m rate of purchases remained steady at $82bn, the slowest pace since early 2013. And the forward indications of foreign demand for US corporate bonds are mixed at best, and will almost certainly be levered to investors' willingness to take open (unhedged) positions in US-dollars.

At some stage, global investors may be freed from the knotty challenge of balancing foreign credit risk with foreign currency risk, should global yields continue to rise, opening up domestic alternatives. (See: North America Multi-Asset Focus – Foreign Flows in US Fixed Income). Buying USD without costly FX hedges is an alternative but less likely with DXY at 18 month highs." - source CITI
So while everyone and their dog are focusing on what is happening in equities with the "great rotation" from growth to value and the "repricing" it entails, us, being part of the "Last of the Romans" when it comes to assessing "credit risks", we'd rather focus on what is happening in credit flows.
"I think the history of the world suggests if one studies the Romans, and one studies the early Greeks, and one studies the history of the world, they all eventually falter if they don't come back to the basic aspect of integrity and honor and feelings of love one for another." -  Jon Huntsman, Sr.
Stay tuned !  
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